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T.C. Memo. 2005-114
UNITED STATES TAX COURT
MILLER & SONS DRYWALL, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1241-03.
Filed May 19, 2005.
Rodger G. Mohagen, for petitioner.
David W. Sorensen, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge:
On January 6, 2003, respondent issued a
notice of deficiency determining Federal income tax deficiencies
for petitioner’s tax years ended June 30, 1998, 1999, and 2000,
of $82,686, $83,016, and $103,855, respectively.
Among other
things, respondent partially disallowed petitioner’s deductions
for compensation paid to its shareholder-employees of $204,577 in
- 2 1998, $242,227 in 1999, and $292,474 in 2000.
Respondent
disallowed these deductions because he determined that the
compensation petitioner paid to its shareholder-employees was
unreasonable under section 162(a).1
this Court.
Petitioner timely petitioned
After concessions, the remaining issue for decision
is whether petitioner’s payments to its shareholder-employees
were reasonable for the years in issue.
We hold that they were.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference.
When petitioner
petitioned this Court, its principal place of business was in
Fargo, North Dakota.
A.
General Background
Darle Miller (Darle) and his father entered the drywall
construction business in the mid-1970s.
Darle acquired the
drywall construction business from his father before 1980 and
initially operated it as a sole proprietorship.
Darle
incorporated the business on July 1, 1980, as a C corporation.
Darle paid $2,000 for 200 shares of petitioner’s stock, and
Darle’s brother Dean Miller (Dean) paid $2,500 for 50 shares of
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect during the years in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
- 3 petitioner’s stock.2
On June 30, 1982, Dean paid $2,150 to
petitioner for 43 additional shares of its stock, and Darle’s
other brother Rocky Miller (Rocky) paid $4,650 to petitioner for
93 shares of stock.
From June 30, 1982, until June 30, 2000,
petitioner was owned by the three brothers as follows:
Shareholder
Percent Ownership
Darle Miller
Dean Miller
Rocky Miller
51.8%
24.1
24.1
Since its inception, petitioner’s tax year has ended June 30.
B.
Petitioner’s Business
Petitioner’s primary business was interior wall
construction.
Wall construction includes the placing of studs,
insulating the walls, hanging drywall and other wall materials as
required, and drywall taping (collectively, the drywall
construction business).
Since the early 1990s, petitioner has
limited its geographic business area to Fargo, North Dakota, and
Moorhead, Minnesota.
Petitioner was a subcontractor.
It was awarded construction
jobs from general contractors by submitting the lowest bid to
complete a specific job (a lowest bid commodity business).
Petitioner primarily bid on commercial construction projects.
After being awarded a job, petitioner purchased the supplies
2
The record is devoid of an explanation why Darle paid less
than Dean for each share of petitioner’s stock.
- 4 Darle anticipated it needed to complete the job and arranged for
them to be delivered to the job site.
Petitioner maintained a
small inventory of drywall, studs, and mud at its warehouse.
C.
Competition in the Drywall Business
The drywall construction business is a competitive industry
because jobs are generally awarded to the lowest bidder, and
because a minimal capital investment allows a competitor to enter
the drywall construction industry.
A drywall construction
business is established with a capital investment of about $300,
which is used to purchase a tool belt, a screw gun and cord, and
a T-square.
There are no proficiency exam requirements, but
petitioner is required to have a contractor’s license to place
its bids with general contractors.
D.
Petitioner’s Shareholder-Employees
1.
Darle Miller
Darle was the chief executive officer (CEO) and president of
petitioner.
He performed many duties as CEO, including preparing
and submitting job bids, scheduling projects and jobs, hiring and
coordinating employees, coordinating activities between
petitioner and the general contractors, ordering supplies,
dealing with payroll issues, and confronting any problems that
arose.
Darle usually arrived at the office by 7 a.m., opened it
for business, checked messages, and returned phone calls.
common for Darle to deliver supplies and equipment to the
It was
- 5 different job sites when Rocky and Dean were unavailable.
Darle
occasionally even performed labor-intensive tasks including, but
not limited to, hanging sheet rock, drywall taping, and unloading
materials at different job sites.
Darle regularly brought job
plans home with him at night to estimate the cost of completing a
job.
The success of petitioner’s business depended on accurately
estimating the cost of completing a job.
After Darle estimated
the cost of completing a potential job, he determined the amount
petitioner would bid to maximize profits and, at the same time,
remain competitive in the bidding process.
On average, Darle worked 55 hours per week during the years
in issue, but worked 60 to 65 hours per week when petitioner was
establishing itself in the drywall construction industry.
2.
Rocky Miller
Rocky was petitioner’s vice president.
His primary duty was
job-site supervisor, which required him to supervise the workers
on a job site, determine what materials were needed on a job
site, hire and fire employees on petitioner’s behalf, coordinate
the progress of each job with Darle, and perform other day-to-day
operations.
Rocky performed additional duties including, inter
alia, delivering materials to the job sites and performing
physical labor, such as hanging sheetrock, drywall taping,
repairing equipment, and removing snow at the sites.
- 6 A usual workday for Rocky began around 5:30 a.m. with
loading the materials needed at a specific job site into
petitioner’s work trucks.
to the job site.
Rocky then delivered those materials
When petitioner was engaged in many small jobs,
Rocky went to multiple sites during a single workday.
workday ended around 5:30 p.m.
Rocky’s
During the years in issue, Rocky
worked an average of 55 to 60 hours per week.
3.
Dean Miller
Dean was petitioner’s secretary/treasurer.
However, Dean
primarily functioned as a job-site supervisor, which required him
to perform the same duties as Rocky.
Dean’s typical workday and
workweek were similar to Rocky’s.
E.
Compensation Paid by Petitioner to Its ShareholderEmployees
For tax years ended after June 30, 1996, Darle’s base salary
was $300,000, except for the taxable year ended June 30, 1999,
when his base salary was $282,501.
Darle was paid a bonus for
the tax years ended June 30, 1984 through 1997, and 2000.
Darle’s total compensation was as follows:
- 7 TYE
June 30
Base
Salary
Bonus
Total
Compensation
1983
$36,000
$22,000
$58,000
1985
36,000
133,000
169,000
1987
36,000
40,000
76,000
1988
36,000
60,000
96,000
1989
36,000
60,000
96,000
1990
36,000
119,057
155,057
1991
88,000
120,000
208,000
1992
41,000
167,208
208,208
1993
60,000
181,248
241,248
1994
72,000
270,160
342,160
1995
72,000
258,480
330,480
1996
300,000
86,000
386,000
1997
300,000
-0-
300,000
1998
300,000
-0-
300,000
1999
282,501
-0-
282,501
2000
300,000
140,000
440,000
Dean and Rocky each received base annual salaries of $90,000
for each tax year after 1996.
Dean and Rocky were both paid
bonuses during all 3 tax years in issue.
Petitioner paid Dean
and Rocky the same amount of total annual compensation (salary
plus bonus), but the total amounts varied from year to year.
following table represents Rocky’s and Dean’s individual
compensation:
The
- 8 -
F.
TYE
June 30
Base
Salary
Bonus
Total
Compensation
1983
$36,000
$15,000
$51,000
1985
36,000
104,700
140,700
1987
36,000
30,000
66,000
1988
36,000
40,000
76,000
1989
36,000
30,000
66,000
1990
36,000
40,471
76,471
1991
56,404
40,000
96,404
1992
34,900
61,196
96,096
1993
43,200
69,376
112,576
1994
48,000
109,920
157,920
1995
48,000
105,760
153,760
1996
90,000
109,000
199,000
1997
90,000
60,000
150,000
1998
90,000
60,000
150,000
1999
90,000
60,000
150,000
2000
90,000
160,000
250,000
Petitioner’s Financial Condition
From 1980 through 1982, the shareholder-employees
capitalized petitioner with contributions of property totaling
$11,300.
No additional capital contributions were made.
As of
June 30, 2000, petitioner had retained earnings of $781,702 and
total shareholder equity of $793,002.
a dividend.
Petitioner never declared
- 9 OPINION
Section 162(a)(1) permits a taxpayer to deduct “a reasonable
allowance for salaries or other compensation for personal
services actually rendered”.
compensation only if:
A taxpayer can take a deduction for
(1) The payments were reasonable in
amount, and (2) the payments were for services actually rendered.
Sec. 1.162-7(a), Income Tax Regs.
Petitioner argues that the total compensation it paid to its
shareholder-employees was deductible because it was reasonable
under section 162(a).
Respondent avers that the amounts of
compensation for petitioner’s tax years ended June 30, 1998
through 2000, were unreasonable and were, instead, disguised
dividends.
In this case, the parties agree that the sole issue
is whether the payments petitioner made to its shareholderemployees were reasonable.
I.
Applicable Caselaw
Because this case appears to be appealable to the Court of
Appeals for the Eighth Circuit, see sec. 7482(b)(1)(B), we shall
follow the relevant decisions of that circuit, see Golsen v.
Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir.
1971).
Whether the compensation paid by a corporate taxpayer to a
shareholder-employee was reasonable is a question of fact.
Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1323
- 10 (5th Cir. 1987), affg. T.C. Memo. 1985-267; Elliotts, Inc. v.
Commissioner, 716 F.2d 1241, 1245 (9th Cir. 1983), revg. T.C.
Memo. 1980-282; Charles Schneider & Co. v. Commissioner, 500 F.2d
148, 151 (8th Cir. 1974), affg. T.C. Memo. 1973-130.
Situations
indicating that shareholder-employees were not dealing with the
corporation at arm’s length warrant close scrutiny.
This ensures
that no part of the purported compensation was a disguised
dividend.
Owensby & Kritikos, Inc. v. Commissioner, supra; Heil
Beauty Supplies, Inc. v. Commissioner, 199 F.2d 193, 194 (8th
Cir. 1952), affg. a Memorandum Opinion of this Court dated Dec.
13, 1950.
Numerous factors have been used in determining the
reasonableness of compensation, with no single factor being
dispositive.
See Rapco, Inc. v. Commissioner, 85 F.3d 950, 954
(2d Cir. 1996) (applying the factor analysis from the perspective
of an independent investor), affg. T.C. Memo. 1995-128; Owensby &
Kritikos, Inc. v. Commissioner, supra at 1323; Pepsi–Cola
Bottling Co. v. Commissioner, 528 F.2d 176, 178 (10th Cir. 1975),
affg. 61 T.C. 564 (1974); Charles Schneider & Co. v.
Commissioner, supra at 152 (identifying nine factors); RTS Inv.
Corp. v. Commissioner, T.C. Memo. 1987-98 (identifying eight
factors), affd. 877 F.2d 647 (8th Cir. 1989).
But cf. Exacto
Spring Corp. v. Commissioner, 196 F.3d 833, 838 (7th Cir. 1999)
(applying the “independent investor test” rather than the
multiple-factor approach used by the majority of circuits), revg.
- 11 Heitz v. Commissioner, T.C. Memo. 1998-220.
include, but are not limited to:
These factors
(1) Employee qualifications;
(2) the nature, extent, and scope of the employee’s work; (3) the
size and complexity of the business; (4) prevailing general
economic conditions; (5) the employee’s compensation as a
percentage of gross and net income; (6) the employeeshareholders’ compensation compared with distributions to
shareholders; (7) the employee-shareholders’ compensation
compared with that paid to non-shareholder-employees or paid in
prior years; (8) prevailing rates of compensation for comparable
positions in comparable concerns; and (9) comparison of
compensation paid to a particular shareholder-employee in
previous years where the corporation has a limited number of
officers.
The Court of Appeals for the Eighth Circuit has not applied
the independent investor test, but in Wagner Constr., Inc. v.
Commissioner, T.C. Memo. 2001-160, which would have been
appealable to the Court of Appeals for the Eighth Circuit, we
applied the independent investor test as a lens through which we
view each factor.
See also Haffner’s Serv. Stations, Inc. v.
Commissioner, T.C. Memo. 2002-38, affd. 326 F.3d 1 (1st Cir.
2003).
In general, this test questions whether an inactive,
independent investor would have been willing to pay the amount of
disputed compensation on the basis of the facts of each
- 12 particular case.
See Elliotts, Inc. v. Commissioner, supra at
1246; Haffner’s Serv. Stations, Inc. v. Commissioner, supra.
This test allows us to decide whether the amount of compensation
paid to petitioner’s shareholder-employees would have been the
same had they engaged in an arm’s-length negotiation.
See also
Heil Beauty Supplies, Inc. v. Commissioner, supra at 194.
One
important inquiry in applying this test is whether the
corporation’s shareholders received a fair return on their
investments.
See Rapco, Inc. v. Commissioner, supra at 955.
In performing our analysis, we generally review each
shareholder-employee’s compensation separately because whether
his salary was reasonable depends on the services he performed.
See RTS Inv. Corp. v. Commissioner, supra.
In this case, we
shall review Dean’s and Rocky’s salaries concurrently because
they performed similar services for petitioner.
II.
Burden of Proof
Under Rule 142(a), petitioner has the burden of proving that
the compensation paid to its shareholder-employees was reasonable
for deduction purposes.
115 (1933).
See Welch v. Helvering, 290 U.S. 111,
Section 7491(a) provides a taxpayer with the
opportunity to shift the burden of proof to the Commissioner
under specific circumstances.
To shift the burden of proof, a
taxpayer must have complied with all the requirements in section
7491(a).
See Higbee v. Commissioner, 116 T.C. 438 (2001); E.J.
- 13 Harrison & Sons, Inc. v. Commissioner, T.C. Memo. 2003-239.
Here, petitioner has not argued the application of section 7491
nor established that it satisfied the requirements in section
7491.
Nevertheless, we decide this case on the preponderance of
the evidence, and therefore it is unaffected by section 7491.
See Blodgett v. Commissioner, 394 F.3d 1030, 1035 (8th Cir.
2005), affg. T.C. Memo. 2003-212.
III.
Expert Testimony
Leonard J. Sliwoski, C.P.A., Ph.D, testified at trial as an
expert witness on petitioner’s behalf.
William C. Herber,
C.B.A., testified at trial as an expert witness on respondent’s
behalf.
At trial, the parties orally stipulated the
qualifications of both Dr. Sliwoski and Mr. Herber.
Opinion
testimony of an expert is admissible if it assists the trier of
fact in understanding evidence that will determine a fact in
issue.
See Fed. R. Evid. 702.
We decide, as the trier of fact,
the weight afforded a witness’s testimony, and we are not
compelled to accept any testimony even when it is uncontradicted.
See McGraw v. Commissioner, 384 F.3d 965, 972 (8th Cir. 2004),
affg. Butler v. Commissioner, T.C. Memo. 2002-314; Paul E. Kummer
Realty Co. v. Commissioner, 511 F.2d 313, 315 (8th Cir. 1975),
affg. T.C. Memo. 1974-44.
IV.
Evidentiary Issue
Petitioner requests that judicial notice be taken of the
- 14 Risk Management Association (RMA) Annual Statement Studies 19981999, 1999-2000, and 2000-2001, and the Methodology/Disclaimer
from the October 1, 2001, Database of the Executive Compensation
Assessor software and database published by the Economic Research
Institute (ERI).
Respondent objects to petitioner’s request
because petitioner did not indicate which RMA studies it wanted
the Court to take judicial notice of, and the information
contained in both the RMA and ERI materials does not meet the
criteria under rule 201 of the Federal Rules of Evidence and this
Court’s jurisprudence.
Rule 201(b) of the Federal Rules of Evidence provides:
Kinds of facts. A judicially noticed fact must be one not
subject to reasonable dispute in that it is either (1)
generally known within the territorial jurisdiction of the
trial court or (2) capable of accurate and ready
determination by resort to sources whose accuracy cannot
reasonably be questioned.
See also Estate of Reis v. Commissioner, 87 T.C. 1016, 1026-1027
(1986).
These materials were relied on by both parties’ experts to
form their respective opinions.
We have heard the testimony of
both experts and have reviewed their respective reports,
including the materials in issue, which were attached to the
expert reports.
The experts relied on these materials, but they
bolstered their opinions with facts other than those considered
in producing these materials.
Each expert testified, and his
respective opinion was subject to cross-examination.
While an
- 15 expert can rely on data that is not admissible to form his
opinion, such reliance does not elevate the evidence to be
admissible for the truth of the matter asserted.
Fed. R. Evid.
703.
Petitioner contends that even though the ERI data considers
businesses similar to it, “exceptional business data is not
available”.
Petitioner’s statement identifies the issues related
to the application of this data to the instant case.
The ERI and
RMA materials are compilations of data that we do not believe
rise to the level required by rule 201(b) of the Federal Rules of
Evidence.
For these reasons, we do not find these materials
subject to judicial notice.
However, since we analyzed the data
contained therein in the context of the experts’ reports and
testimony, whether these materials are admissible does not change
our analysis.
V.
Compensation Paid for Prior Year’s Services
Petitioner claims that a portion of the total compensation
paid to its shareholder-employees during the tax years in issue
was to remedy past undercompensation.
Under some circumstances,
a taxpayer may deduct compensation paid in one year for services
rendered in prior years.
115, 119 (1930).
Lucas v. Ox Fibre Brush Co., 281 U.S.
But to deduct amounts paid as compensation for
past undercompensation, a taxpayer must show:
(a) Its intention
that part of the current payments compensate employees for past
- 16 services, and (b) the amount of the past undercompensation.
See
Pac. Grains, Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir.
1968), affg. T.C. Memo. 1967-7; Estate of Wallace v.
Commissioner, 95 T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th
Cir. 1992); Haffner’s Serv. Stations, Inc. v. Commissioner, T.C.
Memo. 2002-38; Wagner Constr., Inc. v. Commissioner, T.C. Memo.
2001-160.
The parties stipulated that petitioner’s board of directors
meeting minutes indicate that in the tax year ended June 30,
1985, petitioner intended to compensate its shareholder-employees
for past services.
The record shows that the amount of
compensation paid in that tax year was much larger than it had
been in 19833 and the 4 subsequent years.
This indicates that
the payments were intended to rectify past undercompensation for
services rendered.
No such stipulation exists for the years in
issue, and no board of directors meeting minutes for the years in
issue are in the record.
Additionally, in each tax year ending June 30, 1992 through
1996, the total compensation for a shareholder-employee of
petitioner generally increased or remained consistent.
During
each tax year ending June 30, 1997 through 1999, each of
petitioner’s shareholder-employees received less total
3
These figures are taken from the expert reports.
no compensation figures for 1984 in either report.
There are
- 17 compensation than he had during the June 30, 1996, tax year.
These facts do not support a conclusion that during the years in
issue, petitioner was making catchup payments for the years prior
to 1997.
Of the years in issue, only for the tax year ended June
30, 2000, did petitioner’s shareholder-employees receive
compensation over that paid in 1996.
The record establishes that
this increase resulted from petitioner’s obtaining its most
profitable job ever, not from petitioner’s intention to remedy
past undercompensation.
Even if petitioner intended some of the
payments in issue to remedy past undercompensation, petitioner
failed to establish the amount of the past undercompensation or
how much catchup compensation was allegedly paid during each year
in issue.
Therefore, we hold that none of the compensation
petitioner paid for the years in issue was to remedy past
undercompensation.
We do not include this as a factor in our reasonableness-ofthe-compensation analysis because such a finding would not
necessarily indicate the shareholder-employees were
overcompensated.
Instead, that analysis is based on the factors
discussed below.
VI.
Application of Reasonable Compensation Factors
A.
Employee Qualifications
An employee’s superior qualifications may justify high
compensation for his services.
See Charles Schneider & Co. v.
- 18 Commissioner, 500 F.2d at 152; Wagner Constr., Inc. v.
Commissioner, supra.
Petitioner claims that through Darle’s, Rocky’s, and Dean’s
exceptional qualifications it was able to maintain fairly
consistent yearly sales and remain profitable in a highly
competitive industry.
Respondent agrees that Darle, Rocky, and
Dean did “contribute superior qualifications to the successful
operation of the petitioner[’]s business”.
A factor that contributed to petitioner’s success was
petitioner’s ability to obtain profitable construction jobs.
Petitioner obtained jobs primarily by submitting the lowest bid
to a general contractor, and Darle was solely responsible for
preparing each bid.
Darle’s estimate of the cost to complete a
job was the most significant aspect of preparing a bid.
If
Darle’s estimate was inaccurate, petitioner would neither receive
the job, because its bid was too high, nor make a profit.
Darle
therefore deserved high compensation because of his knowledge and
experience.
Although Rocky was petitioner’s vice president and Dean was
petitioner’s treasurer during the years in issue, the facts
indicate that they primarily performed the duties of job-site
supervisors, not executives.
Each has been working for
petitioner since the early 1980s and worked between 55 and 60
hours per week during the 1990s and 2000.
Petitioner’s financial
- 19 success was directly correlated with completing jobs within
budget.
As supervisors with about 20 years of experience each,
Rocky and Dean made sure each job was completed in an efficient,
cost-effective manner.
Their knowledge and experience warranted
high compensation for their services for each year in issue.
This factor favors petitioner.
B.
Nature, Extent, and Scope of an Employee’s Work
An employee’s position, duties performed, hours worked, and
general importance to the corporation’s success may justify high
compensation.
See Charles Schneider & Co. v. Commissioner, supra
at 152.
1.
Darle
Petitioner argues that Darle was a key employee.
Mr.
Herber, respondent’s expert, similarly opined that Darle was the
key employee of petitioner.
Petitioner’s business model was to
maintain consistent yearly sales.
on two things:
Petitioner’s success depended
(1) Accurately estimating the cost of completing
a job, and (2) completing the job within budget.
Darle was the
sole individual responsible for preparing these bids.
In
addition to performing his duties as petitioner’s CEO, Darle
performed many other tasks.
Darle also testified that he worked
about 50 hours per week during the years in issue.
We believe
that Darle’s 20 years of experience were irreplaceable to
petitioner.
Therefore, we find that the nature, extent, and
- 20 scope of Darle’s work justify high compensation.
This factor
weighs in favor of petitioner with respect to Darle’s
compensation.
2.
Rocky and Dean
Petitioner has not offered any evidence detailing Rocky’s or
Dean’s duties as officers, but the record makes it clear that
Rocky and Dean primarily worked as job-site supervisors.
Petitioner’s position appears to be that job-site
supervisors are important to its success.
We agree.
Because
petitioner’s jobs are awarded in a low-bid process, it was
necessary for petitioner to remain within its budget.
This was
confirmed by Darle’s testimony that employee productivity was one
of the keys to petitioner’s profitability.
this happen.
Rocky and Dean made
According to the Minnesota Work Force Center 1999
Salary Survey, relied on by both experts, Rocky’s and Dean’s
duties appeared to be similar to those of a construction manager
who has numerous responsibilities.
One specific duty of a
construction manager was to make sure a job was completed within
budget.
Both Rocky and Dean had about 20 years of supervisory
experience, and this experience added to petitioner’s success.
Respondent argues that the nature, extent, and scope of
Rocky’s and Dean’s services are not “in any way unique to the
petitioner.”
We do not believe that the uniqueness of their
services is dispositive of this factor.
Rocky and Dean were both
- 21 integral to petitioner’s success, and each averaged between 55
and 60 work hours per week during the years in issue.
Rocky and
Dean arrived at petitioner’s place of business at about 5:30 a.m.
to load the work trucks and deliver the materials to specific job
sites.
Rocky and Dean hung drywall and performed any other
physical task that needed to be done.
Petitioner’s consistent
sales and substantial pretax profit margins before shareholderemployees compensation were due in part to the skills,
dedication, and efforts of Rocky and Dean.
We find the extent
and scope of Rocky’s and Dean’s duties warrant high compensation.
This factor favors petitioner with respect to Rocky’s and Dean’s
compensation.
C.
Size and Complexity of Petitioner’s Business
Courts consider the size and complexity of a taxpayer’s
business when deciding the reasonableness of compensation paid to
its shareholder-employees.
See RTS Inv. Corp. v. Commissioner,
877 F.2d at 651; Charles Schneider & Co. v. Commissioner, 500
F.2d at 152.
A company’s size is determined by its sales, net
income, gross receipts, or capital value.
See Beiner, Inc. v.
Commissioner, T.C. Memo. 2004-219; Wagner Constr., Inc. v.
Commissioner, T.C. Memo. 2001-160.
During the tax years in issue, petitioner was a small
business, as measured by its annual gross sales, and its business
model indicates it was not interested in growth.
After reviewing
- 22 petitioner’s financial documents, both experts concluded that
petitioner’s annual sales were fairly constant during the 1990s.
Petitioner argues that these facts tip the scale in its favor.
Respondent conversely contends that this factor supports the
position that the shareholder-employees were unreasonably
compensated because petitioner’s business was small and simple.
As we understand this argument, respondent believes petitioner’s
business was simple because a competitor could establish a
drywall construction business for a mere $300 investment, and
because the drywall business did not require substantial
scientific and highly technical knowledge.
See B & D
Foundations, Inc. v. Commissioner, T.C. Memo. 2001-262.
We do not agree with either party’s analysis.
Petitioner’s
consistent sales and net income do not show that its business was
large or complex.
Nothing in the record supports a finding that
petitioner’s business was different from any other drywall
construction business, except that its business model was to
maintain consistent yearly sales.
An independent investor would
have been unwilling to increase an employee’s compensation where
the corporation is not expected to increase sales because that
could have decreased the investor’s return (assuming costs
remained the same). Similarly, an independent investor might have
been hesitant to increase an employee’s compensation where the
employee had no substantial or specified training.
- 23 On the other hand, although the drywall business did not
require highly technical knowledge, petitioner’s shareholderemployees developed the skills and methods to accurately bid on
and complete projects within budget.
An individual could have
entered the drywall construction business with a mere $300
investment, but there was no guarantee of success.
Darle
credibly testified that a number of competitors emerged and
failed since petitioner has been in existence.
Petitioner has
been engaged in the drywall business for more than 20 years, and
its success depends on the time-tested skills and judgment of its
key employees.
In a competitive industry such as this,
petitioner’s development of business methods and techniques
directly related to its success.
The successful execution of
these methods was complex or, at a minimum, difficult.
We also
believe that the leanness of petitioner’s management and the
multiple duties each shareholder-employee performed further weigh
against respondent.
Consequently, we find this factor to favor
petitioner.
D.
General Economic Conditions
Another factor we take into consideration is the employee’s
impact on the corporation’s success compared to the impact of the
general economic conditions.
supra at 651.
See RTS Inv. Corp. v. Commissioner,
This comparison helps indicate whether the
- 24 business’s success is attributable to the employee’s prowess and
acumen or to other economic factors.
Petitioner argues its business was insulated from the
existing economic conditions.
Dr. Sliwoski’s report states that
petitioner was shielded from economic fluctuations when compared
to other similar businesses because of its exceptional management
and business model that focused on consistent sales rather than
growth.
Dr. Sliwoski did acknowledge in his report that the
economic conditions were favorable for the entire construction
industry during much of the 1990s.
Given the favorable economic
conditions, respondent urges us to hold that the compensation
petitioner paid Darle, Rocky, and Dean was unreasonable.
We
agree that the economic conditions were favorable, but whether
this factor supports either party depends on how these conditions
affected petitioner’s business.
Petitioner’s gross yearly sales in the 1990s remained fairly
consistent.
Only during the tax year ended June 30, 2000, did
petitioner have a significant spike in sales.
This spike was
mostly attributable to one large job petitioner had obtained.
Given petitioner’s business model and its consistent annual gross
sales, we believe the economic conditions had, at most, a minimal
impact on its success.
In addition, nothing in the record
indicates that any of petitioner’s shareholder-employees worked
fewer hours because the economic conditions were favorable.
No
- 25 matter how favorable the economic conditions were, petitioner’s
success depended on obtaining jobs through the bidding process
and completing each job within budget.
In other words,
petitioner’s success depended on how well Darle, Dean, and Rocky
performed their respective jobs, not on the economy’s health.
We
hold that this factor weighs in petitioner’s favor because its
success was not a function of economic circumstances.
E.
Comparison of Salaries With Distributions to
Stockholders and Retained Earnings
The Court of Appeals for the Eighth Circuit has stated that
the “absence of dividends to stockholders out of available
profits justifies an inference that some of the purported
compensation really represented a distribution of profits as
dividends.”
Paul E. Kummer Realty Co. v. Commissioner, 511 F.2d
at 315; Charles Schneider & Co. v. Commissioner, 500 F.2d at 153;
see also RTS Inv. Corp. v. Commissioner, 877 F.2d at 651.
Petitioner never declared a dividend.
However, corporations generally are not required to pay
dividends.
In addition, Darle testified that petitioner did not
pay dividends because it wanted a financial cushion in case it
had difficulty obtaining jobs.
of $781,702 as of June 30, 2000.
Petitioner had retained earnings
Respondent would argue that
petitioner’s retained earnings exceeded the amount needed to
sustain its business.
We do not find these amounts so excessive
as to warrant us to second-guess Darle’s business judgment.
- 26 As we have mentioned, the independent investor test measures
whether a corporation’s shareholders received a fair return on
their investment.
Return on equity measures the appreciation of
the stockholders’ investments through the corporation’s
retainment of earnings.
See Owensby & Kritikos, Inc. v.
Commissioner, 819 F.2d at 1326-1327; Home Interiors & Gifts, Inc.
v. Commissioner, 73 T.C. 1142, 1161 (1980); see also Rev. Rul.
79-8, 1979-1 C.B. 92 (stating compensation may be reasonable even
when the corporation never paid a substantial portion of its
earnings and profits as a dividend).
Each party’s expert analyzed whether an independent investor
would consider the amount of compensation paid by petitioner
reasonable in light of the return on equity (ROE) petitioner’s
shareholders received.
To do this, the experts first determined
the appropriate assumed rate of return on equity that an
independent investor would find acceptable for each year in
issue.
The parties do not agree on the assumed equity rate of
return.
The second step is to determine the appropriate period
in which to compare the ROE received by petitioner’s shareholders
with the assumed rates.
appropriate period.
The parties do not agree on the
- 27 1.
Assumed Rate of Return
Both experts used the build-up approach to calculate the
assumed rate of return for the tax years in issue.
The build-up
approach starts with the risk-free rate of return for the year in
issue, and three adjustments are made:
An equity risk
adjustment, a size adjustment, and a company-specific risk
adjustment.
The only adjustment the parties do not agree on is
the company-specific risk adjustment.
This adjustment cannot be
found in reference materials; rather, it requires a factual
determination.
Dr. Sliwoski, petitioner’s expert, found a company-specific
risk adjustment of negative 2.5 percent because he determined
that petitioner was subject to minimal business risks and
extremely minimal financial risk.
By contrast, Mr. Herber,
respondent’s expert, concluded that the company-specific risk
adjustment should be positive 5 percent for each tax year in
issue.
Mr. Herber considered petitioner’s size (as measured by
annual sales), industry risks, lack of management depth, and the
competitive nature of the drywall construction business as
factors in making the company-specific adjustment.
Having reviewed the parties’ respective positions, we
disagree in part with each expert’s company-specific risk
adjustment analysis.
We find the total company-specific risk
adjustment to be negative 2 percent for each year in issue.
We
- 28 make the negative-2-percent adjustment on the basis of
petitioner’s conservative capital structure as reflected in its
ample cash reserves and borrowing capacity as defined by Dr.
Sliwoski, low debt-to-equity ratio, and business model to
maintain consistent yearly sales.
Therefore, we hold that an independent investor would find
the following assumed rates of return acceptable:
Factor
TYE
June 30,
1998
TYE
June 30,
1999
TYE
June 30, 2000
Risk-free rate
6.0%
5.4%
6.8%
Equity risk premium
8.2
8.4
8.5
Size premium
3.3
2.6
4.3
Company specific
risk premium
(2.0)
(2.0)
(2.0)
Assumed rate of
return
15.5
14.4
17.6
The average assumed rate of return for the years in issue was
15.8 percent.
2.
Time Period and Calculation
The parties computed the compound growth rates of
petitioner’s shareholders’ equity for 20-year and 10-year
periods.
Instead of using compound growth rates to determine
whether an independent investor would be satisfied with the
return on its investment, this Court has generally calculated a
corporation’s ROE by dividing its net income after tax for a
specific year by its shareholders equity.
See B & D Foundations,
Inc. v. Commissioner, T.C. Memo. 2001-262 (discussing the ROE
- 29 calculation in greater detail); Labelgraphics, Inc. v.
Commissioner, T.C. Memo. 1998-343, affd. 221 F.3d 1091 (9th Cir.
2000).
Shareholder equity is either the corporation’s
shareholders’ equity at the beginning of that year, e.g., Alpha
Med., Inc. v. Commissioner, T.C. Memo. 1997-464 at n.8, revd. on
other grounds 172 F.3d 942 (6th Cir. 1999), the shareholders’
equity at the end of the year, e.g., Labelgraphics, Inc. v.
Commissioner, supra, or the year’s average shareholder equity,
e.g., Dexsil Corp. v. Commissioner, 147 F.3d 96, 99 (2d Cir.
1998), affg. T.C. Memo. 1995-135; see B & D Foundations, Inc. v.
Commissioner, supra.
We shall apply the general ROE approach in
this case using petitioner’s shareholders’ equity at the
beginning of each tax year in issue.
Moreover, the parties do not agree on the appropriate time
period to determine whether petitioner’s shareholders’ ROE would
satisfy an independent investor.
Petitioner argues that we
should review the entire period it has been incorporated.
Respondent argues that an independent investor would find the 10year period ending with 2000, the last year in issue, to be a
more accurate representation of its investment.
If we were to
consider petitioner’s tax years outside of the 3 years in issue,
we would be inclined to review the entire period it has been
incorporated.
However, given the facts of this case, an analysis
focused on the years in issue is more appropriate.
- 30 Respondent also relies on Alpha Med., Inc. v. Commissioner,
supra, and Eberl’s Claim Serv., Inc. v. Commissioner, T.C. Memo.
1999-211, affd. 249 F.3d 994 (10th Cir. 2001), for the
proposition that the ROE should be analyzed only for each tax
year in issue separately.
Petitioner argues that respondent’s
analysis should not be relied on because he incorrectly
interpreted this Court’s jurisprudence.
We agree that the independent investor would initially focus
on each of the 3 years in issue separately.
However,
respondent’s reliance on Alpha Med., Inc. and Eberl’s Claim
Serv., Inc. is partially misplaced.
Unlike those cases, the
total capital investment of $11,300, as of 1982, made by the
shareholder-employees in this case was not de minimis considering
a competitor could establish a drywall construction business with
only $300.
Also, in this case, there are three shareholder-
employees, compared to a single shareholder-employee in each of
those cases.
These differences sufficiently distinguish this
case from the reasoning used in Alpha Med., Inc. and Eberl’s
Claim Serv., Inc. to view the years in issue only separately.
Thus, we shall consider the years in issue collectively and
separately.
Petitioner’s ROE for the tax year ended June 30, 1998, was
7.8 percent, for the tax year ended June 30, 1999, negative 4.1
- 31 percent, and for the tax year ended June 30, 2000, 41.3 percent.4
The average ROE for the 3 years in issue was 15 percent, which is
very close to our average assumed rate of return.
The average
ROE is slightly less because in the tax year ended June 30, 1999,
petitioner had a negative ROE.
However, the fact that
petitioner’s CEO received less compensation in that year than in
any of the previous 5 years and did not receive a bonus in that
year nullifies any negative inference we would have drawn.
Instead, these facts support the conclusion that Darle’s
compensation was in accord with performance, which was reasonable
for a CEO.
Furthermore, petitioner’s ROE for the tax year ended
June 30, 2000, was substantial.
Analyzing the ROE of the years
in issue together in this case eliminates anomalies created by
fluctuations in a given year.
Therefore, looking at the years
before us together, we hold that this factor favors petitioner.
F.
Comparison of Compensation to Gross and Net Income
Compensation as a percentage of a taxpayer’s gross and net
income has been considered in deciding whether compensation was
reasonable.
See RTS Inv. Corp. v. Commissioner, 877 F.2d at 650.
The comparison of salaries to net income is more important
because it “more accurately gauges whether a corporation is
4
We calculated ROE by dividing the year’s net income by the
year’s beginning total shareholder equity. We used the figures
in the financial documents included in the expert reports to
determine ROE.
- 32 disguising the distribution of dividends as compensation.”
Wagner Constr., Inc. v. Commissioner, T.C. Memo. 2001-160 (citing
Owensby & Kritkos, Inc. v. Commissioner, 819 F.2d at 1325-1326).
Respondent provided a chart that expressed the shareholderemployees’ compensation as a percentage of gross receipts and net
pretax income for tax years ended June 30, 1990 through 2000.
With respect to the years in issue, respondent determined that
the shareholder-employees’ compensation was as follows:
Net income
before taxes
and
shareholder
compensation
TYE
June 30
Compensation
paid to
petitioner’s
shareholders
Gross
receipts
Percent
1998
$600,000
$1,857,221
32%
$673,651
89%
1999
592,727
1,688,437
35
548,980
108
2000
940,000
2,905,034
32
1,277,316
74
Percent
Petitioner argues that this factor should not be afforded much
weight because Darle, Rocky, and Dean each wore “three hats”-directors, officers, and key employees–-which required them to
perform duties above and beyond their respective titles.
While we disagree with both parties’ analyses, we find this
factor favors respondent.
The shareholder-employees’
compensation expressed as a percent of gross income was fairly
consistent in the years in issue and was a significant portion of
the net income.
In some cases, the percentages may be less
indicative because the qualifications of the shareholderemployees and the nature, extent, and scope of their work support
- 33 petitioner’s paying them high compensation.
See, e.g., Mad Auto
Wrecking, Inc. v. Commissioner, T.C. Memo. 1995-153 (deciding
this factor to be neutral where the officers’ qualifications and
the nature, extent, and scope of their work supported high
compensation, but where their compensation represented a
significant percent of gross income and book net income (before
deducting the officers’ compensation) and even exceeded the
amount of net income in a tax year).
However, in this case we
think the percentages favor respondent because petitioner’s
shareholder-employees’ compensation was a substantial portion of
its net income and even exceeded its net income in the tax year
ended June 30, 1999.
G.
External Comparison
This factor compares the shareholder-employees’ salaries to
the salaries that similar companies pay for similar employee
services.
See Elliotts, Inc. v. Commissioner, 716 F.2d at 1246.
In this case, salary surveys were used by both parties’ experts.
1.
Darle--Petitioner’s CEO
With respect to Darle’s compensation, Dr. Sliwoski relied on
ERI’s compensation tables for the comparison.
He testified that
the proper standard industry code (SIC) for petitioner’s drywall
construction business was SIC 1742, “Plastering, Drywall, and
Insulation”.
3:
His report included a table which was titled “Table
SIC 1742: Chief Executive Officer Compensation: Years Ended
- 34 June 30, 1998 through June 30, 2000”.
After reviewing the
attachments to the report, it is clear that Dr. Sliwoski included
data from SIC 1799, “Special Trade Contractors”, not SIC 1742.
Dr. Sliwoski testified that he used the SIC 1799 data because it
includes a broader pool of construction industries than SIC 1742
and provides maximum compensation figures.
Respondent exhorts us to disregard petitioner’s expert’s
report and testimony with respect to the external comparison
analyses because they both relied on the incorrect SIC.
In this
case, we agree such action is warranted because both experts
agreed that SIC 1742 was the most relevant, not SIC 1799.
See
Helvering v. Natl. Grocery Co., 304 U.S. 282, 295 (1938) (holding
that the trier of fact is not bound by any expert witness’s
opinion and may accept or reject expert testimony, in whole or in
part, in the exercise of sound judgment).
Mr. Herber correctly used SIC 1742 to compare Darle’s
compensation.
The ERI data indicates the total compensation for
CEOs in the 90th percentile5 was $183,805, $184,499, and $235,270
for 1998, 1999, and 2000, respectively.6
According to the ERI
data, Darle was compensated substantially above similarly
situated CEOs whose compensation was in the 90th percentile.
On
5
Ninetieth percentile means that only 10 percent of the
year’s data lies above this figure.
6
The ERI date was based on calendar years, but the tax years
in issue were fiscal years ending on June 30.
- 35 the basis of this data, Darle’s experience, and petitioner’s
strong profitability before taxes and shareholder-employee
compensation, Mr. Herber estimated a high and low total
compensation range.
At first glance, the ERI data from SIC 1742 appears relevant
because it is based on the proper SIC and is limited to
businesses in the Fargo, North Dakota, area, and it accounts for
petitioner’s size as measured by revenues.
However, the ERI data
does not take into account the number of hours the similarly
situated CEOs worked or the duties they performed.
Darle was
solely responsible for determining the amount petitioner would
bid on each job.
However, the ERI data does not indicate that
the CEOs in similar companies also had this responsibility.
In
addition, Darle performed many tasks that may not be
traditionally performed by a CEO.
The ERI materials included in
the record fail to indicate whether other CEOs performed similar
tasks.
The ERI data also does not state the business model of
the corporations included in its data.
It is plausible that CEOs
working under different business models may expect to be
compensated differently.
Considering these facts, we place
little weight on these materials and are unwilling to conclude
that the ERI data is sufficient for us to find that Darle’s
compensation was unreasonable.
- 36 Mr. Herber relied on the National Institute for Business
Management (NIBM) Executive Compensation Survey and the RMA
studies in addition to the ERI data to compare Darle’s
compensation.
The NIBM data Mr. Herber relied on was for
companies most similar to petitioner on the basis of overall size
in terms of revenues, having sales volume of less than $5
million, and businesses classified as construction, contracting,
or extraction.
However, at trial, Mr. Herber testified that
NIBM’s survey group included industries that were not comparable
to petitioner’s, including mineral extraction, and we shall not
rely on the information contained therein.
Mr. Herber also used the RMA data to compare Darle’s
compensation, represented as a percentage of income, to a subject
group composed of companies in the SIC 1742 category and having
revenues similar to petitioner’s.
Officer-shareholder
compensation is expressed as a percentage of total revenue.
For
1997 through 1999, officer-shareholder compensation represented
as a percentage of revenues was as follows:
Calendar year
25th
percentile
Median
75th
percentile
1997
2.8%
4.4%
7.7%
1998
3.2
5.1
7.5
1999
3.7
5.0
7.4
Darle’s compensation as a percentage of total revenues for
the tax years ended June 30, 1998 through 2000, was 16.2 percent,
- 37 16.7 percent, and 15.1 percent, respectively.
These figures
indicate that Darle’s compensation expressed as a percentage of
total revenue exceeded the 75th percentile.
Mr. Herber then attempted to calculate Darle’s reasonable
compensation using these percentages.
We do not believe that
such a computation is possible because the RMA data is provided
only up to the 75th percentile.
Nor do we believe that
estimating the percentage for petitioner’s CEO is appropriate or
accurate.
This factor is neutral, with respect to Darle, because the
parties failed to provide comparable compensation data that was
persuasive.
2.
Petitioner’s Other Officers/Job-Site Supervisors
Rocky and Dean both had officer titles but primarily
performed duties as job-site supervisors.
Both parties’ experts
relied on information from the Web site of the Minnesota Work
Force Center (MWFC) of the Minnesota Department of Economic
Security and determined that Rocky’s and Dean’s job
responsibilities are analogous to those of “construction
managers”.
The MWFC 1999 salary survey that estimated
construction managers’ salaries for the fourth quarter 2000 is
summarized below.
- 38 -
Average
10th
percentil
e
25th
percentil
e
50th
percentil
e
(median)
75th
percentil
e
90th
percentil
e
Hourly
wage
$26.47
$15.27
$20.04
$24.62
$28.88
$42.39
Annual
salary
55,073
31,771
41,670
51,196
60,070
88,171
For each year in issue, Rocky and Dean were each compensated
above the 90th percentile annual salary amount.
Mr. Herber used
the 90th percentile as the starting point to determine the amount
of reasonable compensation for their services.
Mr. Herber determined that four additional factors should be
taken into consideration when determining whether the
shareholder-employees were overcompensated.
The first factor
considers whether a shareholder-employee’s expertise enhanced the
corporation’s profitability.
Mr. Herber determined, and we
agree, that Rocky’s and Dean’s prowess contributed to
petitioner’s profitability.
The second factor considers a
shareholder-employee’s experience.
We have already concluded
that both Dean and Rocky had significant and valuable experience.
The third factor considers the number of hours the shareholderemployee dedicated to the taxpayer’s business.
We have also
found that Rocky and Dean have both dedicated between 55 and 60
hours per week to petitioner’s business.
This factor is
particularly significant because it appears that the average
hourly rate of $26.47 was simply calculated by dividing the
average annual wage of $55,073 by 52 weeks and then by 40 hours
- 39 per week.
This simple calculation indicates that Rocky and Dean
were deserving of compensation beyond that contained in the MWFC
tables.
The final factor considered was the level of management
required for the drywall installation business versus overseeing
the construction of an entire building.
Clearly, the level of
supervision is less in the drywall business as it is merely an
aspect of constructing an entire building.
Considering these
factors, we hold that Dean and Rocky deserved to be compensated
above the 90th percentile as found in the MWFC data.
Annualizing the 90th percentile hourly wage on the basis of
a 55-hour work week reveals that Rocky and Dean would have
received about $121,235 in compensation per year.
Rocky and Dean
would have then received compensation that exceeded the 90th
percentile annual income adjusted for the number of hours worked
by 23.7 percent for tax years ended June 30, 1998 and 1999, and
100.6 percent for the tax year ended June 30, 2000.
Taking into
consideration the four factors that Mr. Herber identified, we
believe that Rocky and Dean deserved to be compensated above this
adjusted amount.
Their experience and the nature, extent, and
scope of their work support this conclusion.
the facts, we find this factor to be neutral.
After weighing all
- 40 H.
Petitioner’s Salary Policy as to All Employees
Courts have considered the salary policy of the taxpayers as
to all employees (sometimes referred to as internal consistency)
in determining whether its shareholder-employees received
reasonable compensation.
See Charles Schneider & Co. v.
Commissioner, 500 F.2d at 152; Home Interiors & Gifts, Inc. v.
Commissioner, 73 T.C. at 1159.
This factor is probative because
it questions whether the shareholder-employees, because of their
status as such, were compensated differently from petitioner’s
other employees.
See Owensby & Kritikos, Inc. v. Commissioner,
819 F.2d at 1329.
For example, a reasonable, longstanding, and
consistently applied compensation plan is evidence of reasonable
compensation.
See Elliotts, Inc. v. Commissioner, 716 F.2d at
1247.
In this case, petitioner paid bonuses to its nonshareholder-employees and shareholder-employees.
The bonuses
that the nonshareholders received were not paid annually,
appeared never to exceed their respective annual compensation,
were relatively insignificant in amount, and were not part of a
longstanding, consistently applied compensation plan.
Conversely, the bonuses paid by petitioner to its
shareholder-employees were paid annually (except that Darle did
not receive a bonus in 1997, 1998, or 1999), and they often
exceeded each shareholder-employee’s base annual salary.
More
- 41 importantly petitioner paid its shareholder-employees annual
bonuses regularly, unlike its non-shareholder-employees.
On the
basis of these facts, this factor favors respondent.
I.
Petitioner’s Pretax Profit Margin
Petitioner claims that its pretax profit margin before
shareholder-employee compensation indicates that it was
exceptionally well managed.
The pretax profit margin before
shareholder-employee compensation was calculated by dividing the
pretax net income before shareholder-employee compensation
expense by annual sales.
Conversely, respondent argues that
petitioner’s mean pretax profit margins after shareholder
compensation for the years at issue and over a 10-year period
were virtually identical to the industry average.
After comparing petitioner’s pretax profit margin before
shareholder-employee compensation to RMA’s annual statement
studies, which were for SIC 1742, we find that petitioner had an
exceptional pretax profit margin before shareholder-employee
compensation for each tax year in issue.
This indicates
petitioner’s shareholder-employees were deserving of high
compensation.
However, we are mindful that petitioner’s pretax
profit margin after shareholder compensation was not exceptional,
and the compensation paid to petitioner’s shareholder-employees
depleted its earnings significantly.
Nevertheless, we find this
factor to be neutral for each year in issue because the profit
- 42 margin after shareholder compensation was near the industry
average, and we see no compelling reason to require an aboveaverage return.
VII.
Conclusion
A preponderance of the evidence shows that petitioner’s
shareholder-employees were reasonably compensated for each year
in issue.
Therefore, petitioner may deduct in full the
compensation it paid to Darle, Dean, and Rocky for each year in
issue.
To reflect the foregoing and give effect to the parties’
concessions,
Decision will be entered
under Rule 155.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.